As explained by the Securities and Exchange Commission (SEC) in its publication entitled “Invest Wisely: Introduction to Mutual Funds,” a mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, other assets, or some combination of these investments. The combined holdings the mutual fund owns are known as its portfolio. Each share represents an investor's proportionate ownership of the fund's holdings and the income those holdings generate.
Investors often turn to mutual funds to save for retirement and to achieve other financial goals because mutual funds can offer the advantages of diversification and professional management at an affordable price. Mutual funds accommodate investors who have modest sums of money to invest by setting relatively low dollar amounts for initial purchases, subsequent monthly purchases, or both. Accordingly, many investors find it easier to achieve diversification through ownership of mutual funds, rather than through ownership of individual stocks or bonds. For example, when invested in mutual funds, investors benefit from the stewardship of professional money managers who research, select, and monitor the performance of the securities the fund purchases. Additionally, these professional managers diversify the fund's portfolio by spreading the fund's investments across a wide range of assets.
However, even though mutual funds can offer diversification at affordable prices, there are literally thousands of mutual funds from which investors can choose. These funds have varying investment strategies and assume varying amounts of risk. Most mutual funds fall into one of three main categories: money market funds, bond funds, or stock funds. Each type has different features and different risks and rewards. Generally, the higher the potential return, the higher the risk of loss.
Money market funds have relatively low risks, compared to other mutual funds. By law, they can invest in only certain high-quality, short-term investments issued by the U.S. government, U.S. corporations, and state and local governments. Investor losses have been rare, but they are possible. Money market funds pay dividends that generally reflect short-term interest rates, and historically the returns for money market funds have been lower than for either bond or stock funds. Inflation risk, which is the risk that inflation will outpace and erode investment returns over time, can be a potential concern for investors in money market funds.
Bond funds generally have higher risks than money market funds, largely because they typically pursue strategies aimed at producing higher yields. Unlike money market funds, applicable laws do not restrict bond funds to high-quality or short-term investments. Because there are many different types of bonds, bond funds can vary dramatically in their risks and potential rewards. Some of the risks associated with bond funds include the risk that one or more of the borrows whose debt makes up the fund is unable to repay the amount loaned, the risk that interest rates will rise above the interest rate paid by bonds making up the portfolio, and the risk that the borrowers whose debt makes up the fund will prepay the amounts owed.
Although a stock fund's value can rise and fall quickly and dramatically over the short term, historically stocks have performed better over the long term than other types of investments, including corporate bonds, government bonds, and treasury securities. The market risk poses the greatest potential risk for investors in stocks funds. Stock prices can fluctuate for a broad range of reasons, such as the overall strength of the economy or demand for particular products or services.
Within the broad category of stock funds, there are subcategories having varying investment strategies and risk tolerances. For example, growth funds focus on stocks that may not pay a regular dividend but have the potential for large capital gains. Income funds invest in stocks that pay regular dividends. Index funds aim to achieve the same return as a particular market index, such as the S&P 500, by investing in all of the companies included in an index. Sector funds may specialize in a particular industry segment, such as technology or consumer products stocks.
Some investors are confused by the complexities of the multiple investment choices that are available. However, to achieve long-term financial goals, it is sometimes necessary for investors to invest in multiple mutual funds, each having a different investment strategy. Further, as investors progress through their lifecycle toward their long-term financial goals, asset reallocation is necessary. For example, many investors reallocate their assets to more conservative investments as they approach retirement by shifting some investments from stock funds to bond funds or from bond funds to money market funds. However, effective asset reallocation is difficult and many investors fail to properly reallocate.
As explained by the SEC in its Beginners' Guide to Asset Allocation, Diversification, and Rebalancing, to accommodate investors who prefer to use one investment to save for a particular investment goal, such as retirement, without having to worry about the complexities of asset reallocation, some mutual fund companies offer a product known as a “lifecycle fund.” A lifecycle fund is a diversified mutual fund that automatically reallocates towards a more conservative mix of investments as it approaches a particular year in the future, known as its “target date.” A lifecycle fund investor picks a fund with the right target date based on his or her particular investment goal. The managers of the fund then make decisions about asset allocation, diversification, and rebalancing based on what they think is best for the collective group of investors who own the fund.
However, because life cycle funds become very large over the years and become subject to more and more regulatory constraints, these funds become difficult to manage. The constraints limit managers flexibly when reallocating, diversifying, and rebalancing assets. Further, lifecycle funds may not always be an appropriate investment for some investors because changes over time in the funds' overall asset allocation mixes may not match an investor's individual financial goals.